by Dudley Cooke
I develop a two country general equilibrium model with heterogeneous price-setting firms to understand how shocks to monetary policy and aggregate labor productivity impact trade integration, which I capture through the (inverse) average productivity of exporting firms. A contractionary domestic monetary policy shock raises the average productivity of domestic exporting firms but lowers the average productivity of foreign exporting firms. The magnitude of these changes is greater when governments target domestic price inflation as opposed to consumer price inflation. A positive shock to domestic labor productivity generates positive – although quantitatively small – changes in the average productivity of all exporting firms when consumer price inflation is targeted. When domestic price inflation is targeted, the same shock causes a fall in the average productivity of domestic exporting firms, and a far larger rise in the productivity of foreign exporting firms.
The author allows monetary policy shocks to influence heterogeneous firm export decisions in a model setting a-la Melitz (2003). Fixed costs of exporting shrink following a contractionary monetary policy due to the inflation decline. More firms export, which drives up their wage bill and consequently their marginal costs. This causes re-allocation (only the most productive firms continue to export) and increases the average productivity of exporters. The transmission mechanism is interesting but in reality may operate at longer time horizons than those proposed by the author. How quickly do monetary policy decisions lead to lower inflation rates and, consequently, lower export costs that cause the resource reallocation?